Pakistan’s Economic Challenges (Part 1): The Trade Deficit

In Pakistan, it is evident that a slower defence modernization effort stems from stagnant funding, both in fiscal terms (i.e., the national budget) and monetary strength. The latter, which is the exchange-rate of one’s national currency, influences the affordability of big-ticket weapons.

This dynamic is a result of the fact that Pakistan imports its marquee weapons and the critical subsystems of its domestic products. These purchases occur in foreign currency, such as the Dollar, Pound, Euro, etc.

In Pakistan, a significant source of that monetary support had come from US military aid. In fact, Pakistan’s most extensive defence modernization phases occurred in the periods where it received the most US aid – i.e., the 1950s and 1960s, the 1980s, and the mid-to-late 2000s.

However, more recent geo-political realities have pushed Pakistan to now mostly rely on its own economy to drive defence modernization. Given the slower-than-average GDP growth-rate, a correspondingly slow pace of defence procurement should not be surprising.

But the Pakistani military will require new large-scale acquisition projects in some areas, notably in terms of next-generation combat aircraft (e.g., Project Azm). It would also benefit from significant projects in a number of other domains, but may temper expectations due to limited funding (e.g., armoured vehicles, small arms, etc).

The challenge – which, interestingly, is as old as Pakistan itself – stems from relatively limited funding via the national economy. However, defence is capital intensive, and its demands will grow as Pakistan’s main adversary works to advance its own military – with a much larger and better integrated economy sustaining it.

Quwa will explore Pakistan’s economic challenges in detail through a series of articles. This week, Quwa Premium will start by examining Pakistan’s economic challenges and impact on defence at a high-level – and in subsequent articles, delve into each cause more thoroughly.

A Weakening Currency and Growing Debt

In terms of sustaining defence procurement, Pakistan’s weaknesses stem from a weakening currency and mounting debt-servicing obligations. Not only does the latter mean less money for defence, but also thin support for health and education, further weakening economic development.

The weak currency and high debt relationship is an outcome of Pakistan’s imports costing more than the value of its exports. In Q4 2019, the State Bank of Pakistan (SBP) recorded a current account balance, i.e., the difference of subtracting imports from exports, as a $661 million US deficit.[1] Though the deficit is on the decline since 2018, much of it is driven by throttling or slowing imports through currency devaluation.

Basically, the current Government of Pakistan opted to let the market value the Pakistani Rupee (PKR). In the simplest sense, to import a good one must trade in the currency of the seller. In other words, one will ‘buy’ the currency of the seller (e.g., USD if one is buying from the United States) by selling the PKR.

In turn, the market now has more PKRs circulating on the market compared to the Dollar, and as a result, the PKR is now worth less relative to the USD. However, if one is a strong exporter, they will see a demand for their own currency from other foreign buyers. So, other countries would buy PKRs out of the market, and in turn, raise its value. The result of these ‘transactions’ would, in part, set the value of the currency.

However, Pakistan’s monetary situation faces a specific problem: It is not exporting enough value to drive up the value of the PKR naturally. The previous Pakistani government under the PML-N artificially propped the PKR by injecting foreign currency from loans.[2] This policy had the consequence of incentivizing locals to continue importing as they did not feel the decline in affordability, which occurred under the PTI.

That said, it would be simplistic to paint the PML-N’s decisions as solely self-damaging. Rather, if not for propping up the PKR, Pakistan’s imports of necessity – especially energy and machinery – would also rise in price, making domestic manufacturing more expensive, and less competitive.

Moreover, Pakistan is not energy independent, so costly fuel would make industrial growth difficult. But in 2018, Pakistan imported $17.1 billion US in various types of fuel, $10.6 billion US in machinery, and $3.7 billion US in iron and steel.[3] The top three exporters to Pakistan are China, the United Arab Emirates, and Saudi Arabia.[4] Likewise, Pakistan’s biggest trade deficits are in these three markets.[5]

Unfortunately, Pakistan did not benefit from high-value exports resulting from the PKR’s forced valuation, so it did not generate the foreign currency needed to repay the debt. PTI opted to accept the fall-out, but like its predecessors, cannot lean on high-value exports to sustain energy and machinery imports. Thus, it required loans in foreign currency to sustain the outflows for fuel/machinery, and to honour outflows for past debts, remittances from foreign direct investment (FDI), and other ‘losses.’

Tying Back to Defence

The weakened PKR obviously makes defence imports costlier, but the secondary impact is from the debt Pakistan must take on to honour its outflows. Basically, with more foreign currency going towards those outflows, the armed forces will have less to work with when it comes to importing.

Without strong inflows, Pakistan will continue taking debt in order to repay debt and other outflows. And fiscal budgetary growth in PKR will not help much in terms of imports, not unless the PKR’s value rises. In addition, domestic programs (e.g., the JF-17) are not immune as critical subsystems – notably propulsion, electronics and superstructure materials – are also imported. There is no foreign currency ‘immunity.’

So, in the absence of a massive cash windfall, Pakistan is functionally ‘stuck.’

Cue the China Pakistan Economic Corridor (CPEC). In a sense, CPEC is actually aimed at addressing some the underlying problems preventing Pakistan from generating high-value exports.

So, with a glut of new transport infrastructure, Pakistani manufacturers can cut the cost of shipping their goods, and price their goods competitively. Likewise, there would be a larger energy market in Pakistan, so electricity and fuel should be available at a lower cost to local manufacturers.

The lower transportation and manufacturing costs should make Pakistani goods more competitive, and in turn, make it easier for Pakistan businesses to engage in foreign markets.

Likewise, Pakistan can also collect tolls and taxes through all of these economic transactions, so even the government will have more money to work with for health, education, and defence.

Unfortunately, in its most benign sense, CPEC is an example of ‘putting the cart ahead of the horse.’ Yes, in theory Pakistani manufacturers need ample transportation infrastructure, but Pakistan actually needs the manufacturers in place as well. CPEC offered a solution to a problem that does not yet exist.

To be fair, CPEC’s architectures recognized this to an extent, so they made provisions for special economic zones (SEZ). In turn, these SEZs were to attract FDI as well as build domestic investor confidence. Likewise, there were even reports of building high-tech SEZs, including aerospace (for the Pakistan Air Force’s next-generation fighter requirements no less).[6] But CPEC’s focus is not direct sector investment.

In other words, someone else – be it the Government of Pakistan, Pakistanis, foreign investors, or another entity entirely – must take advantage of CPEC’s groundwork and make those direct sector investments.

By ‘direct sector investment’ we refer to funding manufacturing units that produce goods in the world’s most valuable trading domains. Today, Pakistan’s highest value exports are driven by textile products and agriculture, while manufacturing is its third leading source. However, Pakistan’s ‘manufactured’ products are mostly of leather, footwear and sports goods.[7]

The World Economic Forum (WEF) states that the following goods generate the most value through trade:

• automobiles (1.35 trillion US);
• refined petroleum ($825 billion US);
• integrated circuits ($804 billion US);
• vehicle parts ($685 billion US);
• computers ($614 billion US);
• and pharmaceuticals ($613 billion US).

Thus, Pakistan’s exports (which did see growth since 2018) are not cutting through into any of the most valuable trade areas in the global market. However, manufacturing across each would not only enable the Pakistani economy to export high-value goods, but also cut its imports through local industry. So, it would be a double gain, but no outsider (especially in China and the GCC, which benefit from Pakistan’s deficits) is interested in supporting industrial development in those areas. It must come from Pakistanis.

Finding a Solution

Stating, ‘Pakistan must boost its high-value exports’ is superficial – the real question is, “how?” Ideally, a Pakistani government could directly invest in these areas, be it through grants to entrepreneurs, setting-up new state-owned enterprises, or shared-equity ventures with the private sector.

Unfortunately, that money must come from somewhere. The debt cycle is making the availability of said funding difficult, much less other challenges, such as corruption, red-tape and insecurity.

One aspect worth considering is the fact that private Pakistani investors are largely reluctant or simply unable to engage in such investment. Thus, some entity would need to ‘guarantee’ the situation by kick-starting initiatives, and create a situation where direct sector investment is easier. In a sense, the Kamra Aviation City initiative could be an example, which leads to an interesting point.

Pakistan’s economic planners must make use of the resources they have in reality, not theory. While the presence of military-run state-owned enterprises (SOE) will draw the ire of most economic thinkers, these SOEs are a reality. Moreover, they are among Pakistan’s larger economic agents, so if there is a chance at instigating direct sector investment, the guarantee may come through these SOEs.

[1] Trading Economics. URL: https://tradingeconomics.com/pakistan/current-account

[2] Shahbaz Rana. “Govt injected $7b to keep rupee overvalued in recent years.” The Express Tribune. 21 April 2018. URL: https://tribune.com.pk/story/1691123/2-govt-injected-7b-keep-rupee-overvalued-recent-years/

[3] Daniel Workman. World’s Top Exports. 01 March 2019. URL: http://www.worldstopexports.com/pakistans-top-10-imports/

[4] World Bank. URL: https://wits.worldbank.org/CountryProfile/en/Country/PAK/Year/2018/TradeFlow/Import/Partner/by-country

[5] Workman. World’s Top Exports. 01 March 2019.

[6] Maria Abi-Habib. “China’s ‘Belt and Road’ Plan in Pakistan Takes a Military Turn.” The New York Times. 19 December 2018. URL: https://www.nytimes.com/2018/12/19/world/asia/pakistan-china-belt-road-military.html

[7] Quarterly Review of Foreign Trade: July-September 2019. Ministry of Planning Development and Reforms. Pakistan’s Bureau of Statistics.